The Federal funds rate (“Fed funds rate”) is the interest rate at which banks lend to each other overnight. As such, it is a market interest rate. The Federal Reserve Board (“Fed”) sets a target for the Fed funds rate, and keeps the rate on target via open market operations. Unless otherwise specified, references to the Fed funds rate are actually to the Fed funds rate target (also referred to herein as the Fed funds target rate). On any given day, the actual rate may differ from the target rate slightly.
The Fed funds rate target is set by the Federal Open Market Committee (FOMC), the Fed's monetary policy committee. As the U.S. short-term benchmark, the Fed funds rate target influences market interest rates throughout the world. If fixed income traders and investors have one common interest, it is the path of the Fed funds target rate. From time to time, everyone asks the following question: are security prices fair given where I think the Fed funds rate can go over the next year or two?
In formulating opinions about future values of the Fed funds target rate, market participants rely on many inputs: fundamental economic quantities such as GDP (gross domestic product) growth, inflation, and unemployment; press releases of the FOMC and statements of individual board members; the synthesized analyses of economists; and, finally, market prices as an indicator of consensus opinion.
Several ways of backing out market views from security prices are popular among traders and investors. In one such method, changes in Fed fund futures rates are taken to be changes in the path of Fed funds expected by the market. For example, if the current target rate is 1% and the fed fund futures rate in 6 months is 1.10%, it is concluded that the Fed is expected to tighten by an average of 10 bp over the next 6 months. This particular method is not wholly satisfactory for several reasons.
First, the method says nothing about the probabilities that rates will rise above and fall below 1.10%. In the very special case in which only two rates are possible, say 1% and 1.25%, the only way to get an expected rate of 1.10% is if the probability of a 1% rate is 60% and the probability of a 1.25% rate is 40%. But, in the more general case, where more than two rate realizations are possible, there is no way to determine the probabilities of each rate outcome from the expected rate alone.
Second, changes in Fed fund futures rates reveal nothing directly about expected Eurodollar rates or the probabilities of various Eurodollar rates. This is a significant weakness because, particularly for maturities greater than a few months, trades are often more difficult to execute through Fed funds contracts than through Eurodollar futures or Eurodollar futures options. A Eurodollar is a dollar-denominated deposit in a non-U.S. bank. The Eurodollar deposit rate is the interest rate on these deposits. The Eurodollar offer rate refers to the rate paid for a dollar-denominated loan from a non-U.S. bank. Like any other borrowing or lending rate, quoted Eurodollar rates vary across banks. When a single Eurodollar rate is referred to, it is usually an average of quoted rates from large banks in the international money market centered in London. Eurodollar rates are quoted for standard maturities of one month, three months, one year, etc. LIBOR is an example of particular Eurodollar rate. LIBOR is an acronym for the London interbank offer rate. It is the rate that large non-U.S. banks charge other large non-U.S. banks for dollar-denominated loans. The LIBOR rate incorporates a risk premium due to political and credit risk and is usually slightly higher than the Fed funds rate.
Third, as explained below, some of a 10 bp (a basis point (bp) is 1/100 of a percentage point) increase in the Fed funds futures rate is due to the interest rate risk premium rather than to any increase in the expected Funds rate. In fact, if this risk premium were estimated at 20 bp per year, a 10 bp increase over 6 Fed fund futures contracts would indicate approximately no change at all in the expected funds rate.
Other popular ways of backing out market views from prices suffer from similar drawbacks. Calculations using Eurodollar futures rates alone cannot provide a full probability distribution, cannot directly produce views about Fed funds, and must be adjusted for the interest rate risk premium. More sophisticated calculations that make use of Eurodollar futures options can, with care, provide full probability distributions for Eurodollar rates, but the problems of translation to Fed funds rates and of adjusting for the risk premium remain.